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Many investors are sweating the volatile stock market’s hit to their retirement nest eggs. But not one well-heeled family in Florida.
The married couple, who own a private real estate development business, are passing on hundreds of millions in wealth to their two daughters free of gift and estate taxes. Their method: shuffling buildings, stocks and other investments through more than two dozen short-term trusts.
The particular vehicles they use, known as grantor-retained annuity trusts, have three major tax benefits: GRATs move assets out of a taxable estate. They don’t trigger any gift taxes for the donor. And they “freeze” the value of contributed assets, making their future appreciation free of the 40% gift tax and estate tax.
“We live a GRAT lifestyle with these clients,” said Michael Wagner, the co-founder and managing director of investment management at Omnia Family Wealth, a multifamily office in Aventura, Florida. He added that Omnia was “on our 25th GRAT for this family.”
With the White House’s proposed Build Back Better legislation and its impact on taxes in limbo, advisors have time to implement key tax planning techniques.
The most recent vehicle Wagner set up for his Florida clients was prompted by Wall Street’s decline. The S&P 500 index of leading companies is down more than 14% so far this year as big technology stocks like Amazon and Apple get hammered. Inflation, the war in Ukraine, supply chain bottlenecks and a resurgence of COVID-19 in China have all contributed to the worst month for the markets since the pandemic began in early 2020.
Because of a loophole in the Internal Revenue Code, that’s all great news for trusts.
Heads you win, tails you win
By setting up a GRAT so that assets can be swapped in and out, a taxpayer can yank out stocks that have declined and substitute them with stable Treasury bills. The bruised shares are then stuffed into a new GRAT, restarting the two-to-three-year clock to give them time to bounce back.
“A GRAT is really just playing the odds,” said Laura Zwicker, the chair of the private client services group at law firm Greenberg Glusker in Los Angeles. “We take two sleeves of securities we think will perform inversely and put them in separate GRATs. One wins, one loses.”
But even when a GRAT goes “under water” because a battered asset doesn’t bounce back, the grantor comes out ahead if the trust allows asset substitutions. “The beauty of a GRAT is that if it works, you win, and if it doesn’t work, you don’t lose,” said Justin Miller, a partner and the national director of wealth planning at Evercore Wealth Management in San Francisco. At worst, he said, a client is out the legal fees needed to set things up.
William Blair, an investment banking and wealth management firm in Chicago, wrote in a May 2020 note that from a wealth transfer perspective, GRATs are “analogous to a free pull at a slot machine. If the GRAT ‘hits,’ assets are transferred to the beneficiaries free of gift tax. If it doesn’t, the grantor is in the same tax situation as before the GRAT was executed.”
Advisors like Miller see the recent drop in the markets as an attractive opportunity to play those odds and avoid estate taxes. Taxpayers don’t pay that levy until their estates reach just over $24 million for married couples, half that for single persons. The levels are set to revert back to half those amounts come 2026.
Once a taxpayer puts stocks, bonds or stakes in funds or businesses into a GRAT she controls, the vehicle pays her a yearly “annuity,’ calculated as an amount slightly more than the value of the contributed property or cash. At the end of the trust’s life, typically two or three years, whatever is left over goes to the trust’s heirs free of gift tax. (The donor, known as the grantor, doesn’t owe gift tax because she retains control of the trust during its lifetime and thus doesn’t owe that levy on transfers to herself).
Spousal lifetime access trusts are surging in popularity, but they aren’t as simple as some advisors or clients may think.
The annual payments back to the grantor have to clear what the IRS calls its 7520 hurdle , which the agency revises monthly. This May 2022, that benchmark is 3%. Last January, it was 1.6%. In June 2020, at the height of the pandemic, it was 0.6%.
The trick is to put in an asset whose value is expected to boom, like property or stock in a startup, or has declined but is expected to pop back, like shares in Amazon (those plunged 14% on April 29). Why? Because it’s easy to outpace the low interest rate hurdle, and the “excess” gains eventually pass to heirs tax free. The S&P rose nearly 27% in 2021, more than 16% in 2020 and almost 29% in 2019 — massive multiples of the interest required on yearly payments.
Wagner said he has a client who placed just over $3 million in stocks and other investments into a two-year GRAT in April 2020. The interest rate then was 1.2%. By February 2022, the S&P 500 had gained more than 55%, and the GRAT was worth more than $4.2 million. The client thus moved nearly $1.2 out of their taxable estate.
When the total payments back to the grantor equal the original value of what was put into the trust — even though that number has subsequently swelled — the vehicle is called a “zeroed-out GRAT.” The name comes from a 2000 court case in which Wal-Mart heiress Audrey Walton successfully sued the IRS from collecting gift and estate tax on $200 million in two GRATs.
Since then, the vehicles have become a bread-and-butter technique of tax strategies and estate planning. A September 2021 report from ProPublica, based on leaked IRS records, found that more than half of the 100 richest Americans, including Stephen Schwarzman, a founder of the private equity firm Blackstone, and Laurene Powell Jobs, the widow of Apple founder Steve Jobs, have used GRATs and other trusts to pass hundreds of billions of dollars to their children, other family and friends free of gift and estate taxes.
'Pizza and donuts'
Around since 1990 , when Congress gave them the green light, the trusts are periodically attacked by Democratic lawmakers as an unfair loophole that allows the ultra-affluent to funnel tax-free wealth to the next generation. Democratic efforts last year to raise taxes on the rich, including curbing the use of the trusts, fell by the wayside . President Joe Biden’s federal budget proposal in March revives some of the curbs, including forcing trust owners to pay capital gains tax on unrealized appreciation when the trust goes to beneficiaries and requiring it to hold at least $500,000 or 25% of the value of assets contributed, whichever is greater. That latter amount would be taxable. Biden would also require GRATS to have a minimum life of 10 years and end their tax-free asset swaps.
While there would be exceptions for heirs who are spouses, those recipients would owe capital gains tax when they die or sell a GRAT’s assets. Many financial advisors are skeptical Biden’s proposed curb will win approval. “It’s the adult equivalent of promising everyone pizza and donuts every Friday — it’s a wish list,” Miller said.
Omnia’s Wagner said that GRATs work best for single assets, like a chunk of recently fallen stock, whose value tends to rise and fall regularly. “That’s the beauty of a GRAT,” he said. “It’s embracing the volatility.”